"Risks to the Financial Markets From Proposed Legislative Changes"


May 12, 1997

I am pleased to be here this afternoon and to have the opportunity to address members of the Women in Housing and Finance on some of the major regulatory challenges before the Commodity Futures Trading Commission. The CFTC was created by Congress in 1974 as an independent agency with the mandate to regulate futures and option markets in the United States. Since its creation in 1975, the Commission has witnessed a rapid evolution of the U.S. futures markets. On the futures exchanges, we have seen an explosion of trading in financial products such as foreign currency and interest rate futures, leaving the once- dominant trading in agricultural products only a small part of exchange trading today. We have witnessed enormous growth in the use of privately negotiated, customized off-exchange derivatives contracts, again primarily in financial products. We also have seen the establishment of numerous foreign futures exchanges, creating a truly global marketplace.

It is against this backdrop that legislation was introduced in both the Senate and the House earlier this year to amend the Commodity Exchange Act, the law governing futures and option trading. These bills -- now pending before the Senate Agriculture Committee and a Subcommittee of the House Agricultural Committee -- could have a significant impact on our financial markets, including both exchange-traded and over-the- counter derivatives markets.

In my remarks today I would like to address three areas in which the bills -- if adopted -- could dramatically change federal government oversight over our financial markets: first, the professional markets exemption; second, the Treasury Amendment; and third, the exemption from the Commodity Exchange Act for certain over-the-counter derivative transactions.

Both the House and the Senate bills include a provision exempting so-called professional exchange markets from nearly all provisions of the Commodity Exchange Act. Federal oversight of the futures exchanges could be eliminated as long as exchange trading was limited to entities with a net worth of $1 million. The exchanges estimate that approximately 90 percent of their current trading volume is on behalf of such entities. Therefore, it is likely that simple exchange rule changes could convert many markets into professional markets subject to no meaningful federal oversight.

The deregulation of exchange trading possible under the professional markets exemption would greatly restrict federal power to protect against manipulation, fraud, financial instability and other dangers. Although the bills preserve CFTC jurisdiction to bring fraud and manipulation cases after the fact, the Commission would be stripped of many of its regulatory tools designed to prevent those abuses from occurring and to detect them when they do occur.

The proposed professional markets provisions would sweep away many regulatory tools designed to safeguard market integrity. For example, there would be no Commission surveillance of the professional markets, and federal requirements such as large trader reporting, exchange recordkeeping and speculative position limits would be eliminated. Thus, the Commission would not have the data to analyze aberrational price movements on the markets, including suspected price manipulation. Federal requirements of competitive trading, open pricing, audit trail and important trade practice standards also would be eliminated.

Commodity professional trading exclusively on exempted markets would no longer be subject to registration, fitness and sales practice standards. Statutory and regulatory standards relating to the financial integrity of the markets and their participants would be eliminated. The standards abolished would include segregation of customer funds, net capital requirements, financial reporting, margining of accounts and special bankruptcy protections. In sum, the bills could eliminate seventy years of government protection of the integrity of our markets. Given the interconnection between exchange markets, over-the-counter derivatives markets and cash markets, the resulting undetected fraud and manipulation or financial instability in our exchange markets could pose grave systemic risks for the broader financial markets.

The Commission is committed to the principle that professional exchange markets are entitled to a lower level of regulation than markets open to the general public. We recognize that sophisticated institutional traders do not require the same degree of protection as unsophisticated and inexperienced individuals.

The exchanges, however, maintain that they should be able to operate in the same unregulated environment as the over-the- counter markets. This argument ignores the significant differences in these markets. Exchange trading involves important public interest considerations that require a higher level of government oversight than over-the-counter markets.

The use of centralized clearing in exchange trading, for example, creates a concentration of financial risk not present in bilateral over-the-counter transactions. That concentration of risk poses more serious systemic threats to our economy than the decentralized risk of the over-the-counter market.

While both exchanges and the over-the-counter markets perform a vital public service in providing hedging opportunities, there is a strong public interest in protecting the price-discovery and price-basing functions uniquely performed by exchanges. The prices established by the futures exchanges affect trillions of dollars of commercial transactions and ultimately the retail prices for many commodities. This price- discovery function requires protection even if particular sophisticated traders do not.

While the over-the-counter derivative market has grown rapidly over the past decade, that market both complements and competes with futures exchange markets by providing large institutions with a choice of custom-designed, bilateral instruments as an alternative to standardized contracts without counterparty credit risk. Dealers on the over-the-counter market often hedge their resulting exposure on an exchange and thus bring business to the exchanges.

The bills also include provisions to change the so-called Treasury Amendment and the Treasury Department has also proposed its own changes to the Treasury Amendment. The Treasury Amendment to the Commodity Exchange Act currently excludes the interbank market in foreign currency and the dealer market in government securities from the provisions of the Act. Under the pending bills, exchange trading in futures and options on foreign currency and government securities would be free from government oversight as long as the exchanges excluded some element of the general public. These products constitute more than 70% of the trading on the Chicago Board of Trade and nearly 40% of all U.S. futures exchange trading. The bills' provisions would not even preserve the Act's prohibitions on fraud and manipulation for these markets, despite the fact that the Commission's most recent manipulation case involved CBOT's U.S. Treasury note futures contracts.

Some proposed changes to the Treasury Amendment would permit the off-exchange sale of futures and option contracts on foreign currency and government securities to members of the general public without the protections of the Act. Fraud in this area is rampant. The Commission has brought numerous cases involving fraudulent off-exchange sales of foreign currency futures and options since 1990, involving more than 3200 customers who had invested over 250 million dollars. The Commission could lose the regulatory powers necessary to combat such fraud under some of the proposals to change the Treasury Amendment.

The Senate bill and the Treasury Department's proposal would allow financial institutions and securities firms to sell over- the-counter futures and options in foreign currencies and government securities to the retail public without the Act's protections. It is interesting that for decades, policymakers, academics and members of the financial community have debated whether banks should be permitted to sell securities to the public. In contrast, there has been virtually no public attention paid to this relatively obscure provision of the pending legislation that would allow banks to sell inherently risky and complex futures and options to the retail public.

The Commission is extremely concerned about the dangers of sale of these instruments to the retail public by any institution without adequate risk disclosure and other customer protections. Both the nature of these instruments and their risks are commonly unknown or misunderstood. The nature of futures and options, their high degree of leverage, and the volatility of commodity prices lead to a significant risk of loss for customers. Bank customers who purchase futures on United States treasury bonds may well believe that they are investing in instruments insured by the bank and backed by the full faith and credit of the United States government. When interest rates move against them -- as frequently would happen -- these customers could be left with nothing. Although the Treasury Department has been urging Congress to permit banks and securities firms to engage in these sales to the retail public free from the provisions of the Commodity Exchange Act, it has thus far utterly failed to propose customer protections to govern such sales.

The Commission does not believe that any entity, including a bank or securities broker, should be able to sell futures and options to the general public free from such customer protections. Congress has never draw regulatory distinctions in the Commodity Exchange Act based on the nature of the entity selling futures and options to the public. It is not the nature of the sellers, but rather the inherent risk characteristics of the products themselves that give rise to the necessity for regulation.

Neither the federal banking laws nor the federal securities laws currently provide the regulatory protections necessary for the sale of futures to the general public, as the Commodity Exchange Act does. Furthermore, neither the SEC nor the banking regulators have had experience in regulating sales of futures to the general public, as the CFTC has.

The proposed legislation also contains provisions that would exempt certain private over-the-counter derivatives transactions between sophisticated traders, including swaps, from all provisions of the Act except fraud and manipulation. Some proposals would also exempt off-exchange trading of futures on securities and securities indices from the provisions of the Act for the first time.

These statutory exemptions would replace regulatory exemptions adopted by the Commission in 1993. Transforming the current regulatory exemptions into a blanket statutory exemption would eliminate the Commission's ability to modify the exemptions based on developments in the market.

The U.S. over-the-counter derivatives market is a multi- trillion dollar market that includes a large number of rapidly changing products and participants. As has been recognized repeatedly in recent years, the size and nature of this market create a potential for systemic risk to the nation's financial markets that requires vigilance by federal regulatory authorities. Recent crises in the over-the-counter markets, such as the losses by the State of Wisconsin Investment Board, Orange County, Proctor and Gamble, and Gibson Greeting Cards, demonstrate that over-the-counter risks are real and should remain subject to government oversight and governmental authority.

The Commission sees no current need to alter the scope and nature of the exemptions it has granted. If conditions in the over-the-counter markets were to change and federal monitoring were to demonstrate that additional regulatory action was necessary, the Commission currently would be able to act quickly with having to seek changes in the law. The proposed legislation would remove these markets from current government oversight and would eliminate any ability swiftly to respond to new developments. At a time of increasing innovation, complexity and integration in the world financial markets, federal regulators should not have their hands tied if changing conditions require government action.

These are only three of the many issues addressed by the pending legislation. But these three areas alone could have a potentially enormous impact on the integrity of our financial markets. The Commission is committed to working with Congress, the futures industry and all financial market participants to craft legislation that modernizes the Act, but above all we remain committed to protecting the public interest and the integrity of the markets.